RISK ANALYSIS & CB

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Risk versus Uncertainty

Risk refers to a situation in which
possible future events can have
reasonable probabilities assigned.
Probabilities can be:
a priori obtained by repetition or based
on general mathematical principles
statistical empirical, based on past
events

Risk versus Uncertainty

Uncertainty refers to situations in
which there is no viable method of
assigning probabilities to future
random events.

Sources of Business Risk

Economic conditions
Fluctuations in specific industries
Competition and technological
change
Changes in consumer preferences
Costs and expense changes
(materials, services, labor)

Measures of Risk
Probability: an expression of the
chance that a particular event will
occur
A probability distribution describes, in
percentage terms, the chances of all
possible occurrences.
The probabilities of all possible events
sum to 1

Measures of Risk
Expected value: the average of all possible
outcomes weighted by their respective probabilities
n

R Ri pi
i 1

R=
pi =
n =
Ri =

expected value
probability of case i
number of possible outcomes
value in case i

Measures of Risk
Standard deviation reflects the
variation of possible outcomes from
the average.
Calculated as the square root of the
weighted average of the squared
n
deviations of
Ri R 2 pi outcomes
allpossible
i 1
from the expected
value.

Measures of Risk
Coefficient of variation: a measure of risk relative
to expected value
CV is used to compare standard deviations or
projects with unequal expected values.

CV = R

= standard deviation
R = expected value

mpany is considering taking up 2 projects. Both have same lif

uire equal investment of Rs 80 lakhs each and both are estim
ave almost the same yield. As the company is new to this ty
iness, the cash flows arising from the projects cannot be esti
h certainty. An attempt was, therefore made to use profitabili
lyze the pattern of cash flow from either project during the fi
r of operation. The pattern is likely to continue during the life
se projects. The results of the analysis are as follows:
X

Cash flow( in
lakhs)

Cash flow (in

lakhs)

12

0.1

0.10

14

0.2

12

0.25

16

0.4

16

0.30

18

0.2

20

0.25

20

0.1

24

0.10

ch project should the company take up? (809)

CF
12
14
16
18
20

SD (Rs
lakhs)

P
CF*P
0.1
1.2
0.2
2.8
0.4
6.4
0.2
3.6
0.1
2
16
2.190
89

(CF(CF(CFCF*P) CF*P)2 CF*P)2 * P

-4
16
1.6
-2
4
0.8
0
0
0
2
4
0.8
4
16
1.6
4.8

CF

(CFCF*P)

CF*P

(CF-CF*P)2 (CF-CF*P)2 * P

0.1

0.8

-8

64

6.4

12

0.25

-4

16

16

0.3

4.8

20

0.25

16

24

0.1

2.4

64

6.4

16

SD (Rs lakhs)

4.56070
2

20.8

SD of first project is 2.19 lakhs

SD of second project is 4.56 lakhs
But what if life differs, cash flows
differ?
Co-efficient of variance
1 2.19/16 = 13.69%
2 4.56/16 = 28.5%

Capital Budgeting under

Conditions of Risk
To incorporate risk into a capital
budgeting problem:
calculate expected NPV
calculate the standard deviation of NPV

Capital Budgeting under

Conditions of Risk
Net Present Value of expected values
n

Rt
NP V
O0
t
t 1 (1 r f )
NPV
O0
rf
Rt

= expected net present value

= initial investment
= risk-free interest rate
= expected value of annual cash
flows

Capital Budgeting under

Conditions of Risk
Standard Deviation of the present value
t2

2t

r
i 1
f
n

= standard deviation of NPV

t = standard deviation of cash flow in
period t

mpany is considering two mutually exclusive projects X and Y

ect X costs Rs 30,000 and Project Y Rs 36,000. You have bee
en the NPV distribution for each project.
X

NPV estimates

NPV estimates

3,000

.1

3,000

.2

6,000

.4

6,000

.3

12,000

.4

12,000

.3

15,000

.1

15,000

.2

ch project is risky and what is the PI.

CF
3000
6000
12000
15000

P
0.1
0.4
0.4
0.1

3794.73
3

SD (Rs lakhs)

CF
3000
6000
12000
15000

SD (Rs lakhs)

CF*P
300
2400
4800
1500
9000

(CFCF*P)
(CF-CF*P)2 (CF-CF*P)2 * P
-6000 36000000
3600000
-3000
9000000
3600000
3000
9000000
3600000
6000 36000000
3600000
14400000

P
0.2
0.3
0.3
0.2

CF*P
600
1800
3600
3000
9000
4449.71
9

(CFCF*P)
(CF-CF*P)2 (CF-CF*P)2 * P
-6000 36000000
7200000
-3000
9000000
2700000
3000
9000000
2700000
6000 36000000
7200000
19800000

Two other Methods

for Incorporating Risk
Risk-adjusted discount rate (RADR): the risk
adjustment is made in the denominator of the
present-value calculation
K = rf + RP
K = risk adjusted discount rate
rf = risk-free rate (short-term U.S. Treasury
securities)
RP = risk premium

Two other Methods

for Incorporating Risk
Certainty equivalent: a certain
(risk-free) cash flow that would be
acceptable as opposed to the expected
value of a risky cash flow
With the certainty equivalent
method, the risk adjustment is
made in the numerator of the
present-value calculation.

Sensitivity and
Scenario Analysis
Sensitivity analysis: a method for
estimating project risk that involves
changing a key variable to evaluate the
impact the change will have on the results
Scenario analysis: similar to sensitivity
analysis, but takes into consideration the
changes of several important variables
simultaneously

Simulation
Simulation analysis: a method for
estimating project risk that assigns a
probability distribution to each of the
key variables
Uses random numbers to simulate a
set of possible outcomes to arrive at
an expected value and dispersion

Decision Trees
Decision tree: a diagram that points out
graphically the order in which decisions
must be made and compares the value of
the various actions that can be undertaken
Decision points are designated with
squares on a decision tree. Chance events
are designated with circles and are
assigned certain probabilities.